American Recovery and Reinvestment Act: How to Leverage New NOL Legislation

The American Recovery and Reinvestment Act of 2009 (the Act) amended the tax law concerning net operating losses (NOLs) for qualifying small businesses. Currently, eligible small businesses with an NOL in 2008 may now elect to offset the loss against income earned in up to five prior years, rather than two as under the previous law.

Note: An NOL is the excess of business deductions (computed with certain
modifications) over gross income in a particular tax year. This loss can be
deducted in another tax year where gross income exceeds business
deductions. When deducted against previous years, the NOL is said to
have been "carried back." Alternatively, a taxpayer can "carry forward" an
NOL for up to 20 years.

This means small businesses that suffered big losses in 2008, given the state of the economy, can use those losses to offset income earned before the recessionary effects were felt. This could provide small businesses with a quick cash infusion by generating a refund of taxes already paid. Further, the Internal Revenue Service (IRS) provides accelerated methods by which to claim a refund, to get the cash in business owners' pockets now, rather than later (see below).

Although the extended carryback provision is presently available only to eligible small businesses, the Obama Administration is seeking to expand the legislation.

The Treasury's "Greenbook" (explanation of the Administration's tax proposals), issued May 11, 2009, specifically states the Administration will be working with Congress to make a lengthened NOL carryback period available to more taxpayers.

MAXIMIZING THE CARRYBACK

The new NOL rules could result in a refund by allowing a taxpayer to offset income that has already been taxed. Under the previous rules, a taxpayer could not use an NOL to offset income from the third, fourth or fifth year preceding the NOL, and therefore could not receive a refund for taxes paid in these years.

For example: Suppose XYZ, Inc. (a qualifying small business) has an applicable NOL for 2008 (i.e., an NOL that arose in tax years ending after December 31, 2007). XYZ, Inc. had taxable income in 2005 (on which it paid federal taxes), but no taxable income in 2006 or 2007. Under the old rules, XYZ, Inc. would only have the option to carry the NOL back to 2006 or 2007, where it was of no use to the corporation. XYZ, Inc. would have to wait until later years when it had taxable income to carry the NOL forward and receive a tax benefit. Now, under the new rules, XYZ, Inc. will receive a refund of some (or even all) of the taxes it paid on the 2005 income.

Certain "strategizing" could further leverage use of a 2008 NOL. A taxpayer must consider in which year preceding the 2008 NOL—third (2005), fourth (2004) or fifth (2003)—a carryback will generate the most tax savings. If the 2008 NOL is equal to the total combined income for all three years (or greater), then the NOL should be carried back to the fifth year so it could be utilized in all three years. Any remaining NOL could still then be used to offset 2007 or 2008 income (if any), or carried forward to future years. In this way, a taxpayer takes full advantage of the new law.

On the other hand, if the NOL is less than the total combined income for all three years, it would be most beneficial to carry the NOL back to the year in which the taxpayer's income was taxed at the highest rate, because this will generate the highest refund.

ELIGIBILITY

For purposes of the new NOL provisions under the Act, an eligible small business is a corporation or partnership (including limited liability companies) whose average annual gross receipts (as defined under Code section 448(c), and modified by the Act) are $15 million or less, for the three-year tax period (or shorter if the entity has not been in existence for three years) ending with the tax year before the year in which the loss arose.

Note: The normal two-year carryback period remains available for businesses that
do not qualify as an eligible small business, or for eligible small businesses that
do not elect the special carryback provision.

IMPORTANT DEADLINES

In order to utilize the 2008 NOLs under the new rules created by the Act, deadlines must be met, depending on the status of the taxpayer's 2008 return (or the return for the applicable NOL taxable year, if other than a calendar year).

Not yet filed: the taxpayer must attach a statement to the federal income tax return to be filed stating that such election is being made, and the length of the carryback period elected, and must file the return/statement by the due date of the return (determined including extensions).

Already filed and did NOT elect to forgo the NOL carryback period: the taxpayer must file an amended return or applicable refund form by the later of (a) six months after the due date of the return (determined without extensions); or (b) April 17, 2009.

Tip: It is a good idea for a taxpayer to file the appropriate refund form (Form
1065 for individuals and Form 1139 for corporations), as compared to an
amended return, because these forms accelerate the payment of refunds. Thus,
the taxpayer will not have to wait until the IRS processes the return for the NOL
year to get the refund.

Already filed and elected to forgo the NOL carryback period: the taxpayer must have filed an amended return or applicable refund form by April 17, 2009.

Note: Returns and statements must have the proper labels, as mandated by the
IRS revenue procedure issued on March 16, 2009.